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Startup Funding Explained - Seed Round and Stock Option Pool (Part II) - YouTube
Channel: Slidebean
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welcome to part two of our starting a
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company video in this video we're going
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over the journey of a company from the
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founders getting together to fundraising
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to issuing stock to vesting agreements
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and all the way to the company exit and
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kind of explaining how the process works
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for each one of those steps if you
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haven't watched part 1 go and watch that
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because otherwise this won't make any
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sense okay so let's get started
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[Music]
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seed round so after incorporating and
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dedicating time to the business the
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company is doing great the two founders
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managed to build a product launch it and
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our generating revenue let's assume that
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our fictitious company is a SAS business
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that's software as a service it has
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thirty thousand dollars in monthly
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recurring revenue those are customer
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subscriptions that they renew
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automatically every month so the
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business is also consistently growing at
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10 percent per month that translates to
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around 300% and annual growth those are
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good seed round metrics kind like basic
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standard minimum seed round metrics so
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these guys want to keep growing fast and
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accelerate their pace even more so they
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agree to seek out a new round of funding
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this time their goal is racing 500
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thousand dollars so for this stage they
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can start reaching out to angel
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investors outside their family circle
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they use slide min to create a freaking
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awesome pitch deck and start generating
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meetings that's the shameless plug
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anyway we have a video on the process of
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finding investors so go check that out
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if you have any questions so the team
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finds an angel investor and this guy is
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willing to come into this round so what
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percentage of the company do these new
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investors get if we used traditional
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methods to calculate the business
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valuation for example a 5 X multiplier
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of their annualized revenue that's
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actually a standard metric then we could
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say that the business is worth about 2
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million dollars that's $30,000 in
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monthly revenue times 12 times 5 in that
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case these new investors would get a 25%
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chunk of the company which is not that
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fair for founders it will dilute them
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too much too early in the process also
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knowing the potential of the product and
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how fast they're growing the founders
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feel the company is already worth maybe
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5 million dollars if that were the case
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then the new investors would be buying
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around 10% of the nubes
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with their $500,000 investment however
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the investor believes that that's too
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small of a percentage for the risk
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they're taking so what valuation to use
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at this stage the two million or the
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five million somewhere in the middle
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well the answer is neither this is where
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a convertible note comes into play
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convertible notes we also have a full
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video on convertible notes if you want
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to dive deeper into how they work but
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I'm gonna explain it in simple terms
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here considering the founders and the
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investors have no way on agreeing on a
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valuation right now they can use a
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convertible note to hold off on the
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decision of how much the business is
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worth with a convertible note investors
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can come in the company can grow and the
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conversion to stock occurs later a
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convertible note works much like a loan
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except that it's designed to be paid
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back in stock instead of cash how many
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shares of stock well that will be
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determined based on the company
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valuation in the future convertible
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notes are also known as bridge funding
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because they provide quick capital with
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the expectation of a future round so a
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convertible note for this company could
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look something like this a $500,000
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investment will be made in the form of a
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note or a loan the company then assumes
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that with this capital it will be able
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to scale fast getting to the point where
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they can raise a Series A round more
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importantly the money will allow them to
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solidify their market presence it will
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make it easier for future investors to
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define a number that's fair for the
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company valuation so the capital
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invested in this convertible note will
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convert into stock at a future valuation
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that valuation will be defined by the
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investors of the series a round and then
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the seed stage investor will get the
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same terms as the new future investors
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so to compensate this early investor for
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taking an extra risk they will get a
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discount on the valuation of the future
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investors that discount is usually
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around 20% again check out our video on
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convertible notes if you want to
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understand these variables with more
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detail and a few others that I skipped
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just for the purpose of simplicity so
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for this company story notes are issued
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money is in the bank and the company
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continues to grow the cap table or share
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distribution of this company is still
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unchanged the new investor is not a
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shareholder yet the stock option pool at
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this point the company will want to
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recruit some talent these are going to
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be the first employees and it's
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important to keep these guys motivated
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in the startup world it's quite common
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to offer shares of stock to the first
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employees in the company and this is
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done with a stock option pool now the
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stock option pool consists of a defined
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amount of shares that are sort of set
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aside to be issued to employees for an
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option pool our sample company could
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issue say five hundred thousand new
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shares of stock bringing the total
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number of shares to ten million five
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hundred thousand once again those four
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million shares that each one of the
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original founders started the business
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with no longer represent 40 percent of
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the business they still have the four
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million shares but they now represent
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around 38 percent our original investor
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also gets diluted there are two million
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shares no longer represent twenty
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percent of the company there now
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somewhere around nineteen percent so the
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shares on the stock option pool are not
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given to employees mostly because of tax
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purposes if the company just gave say
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one hundred thousand shares to a new key
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employee they would effectively be
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receiving an asset that has a value
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remember how the company valuation was
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two hundred and fifty thousand dollars
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after the first round of investment well
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that means that each share is worth
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around 0.02 three dollars so a hundred
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thousand shares would represent over two
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thousand dollars which would be
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considered taxable income at a small
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valuation this is not a lot of money but
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as the company scales this could bring
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serious tax implications so instead of
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giving the shares to the employees the
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stock option pool is made up of stock
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options the company is offering the
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employee the option to purchase shares
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at a defined and fixed rate so for this
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theoretical company the price could be
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0.02 $3.00 per share because that's the
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last official valuation the company had
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this is called the strike price if the
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company increases in value and the price
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per share increase
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the company still has the option to
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purchase those shares at the original
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strike price that was promised in the
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option book which lets them turn out a
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profit so for the purpose of this
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scenario we're gonna assume that two key
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employees were hired and each one of
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them got 250,000 stock options as our
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theoretical company grows we'll look
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into some scenarios on what happens with
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these stock options
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[Music]
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